Sunday, February 10, 2008

Will 130/30 Funds hold water?

As pointed out in a recent article in Investment Dealers' Digest, 130/30 Strategies are Set to Gain Traction. Hedge funds and major brokerages have been heavily marketing these funds to institutions such as pension funds. The recent tumble in stocks has only increased the marketing blitz and associated claims that these strategies will squeeze out excess alpha in both down and up markets.

As outlined earlier, 130/30 funds allow managers to short-sell up to 30% of their portfolios, and use the proceeds to buy an extra 30% long. The funds both use leverage and short-selling. The current market size is estimated to be $50 billion, many analysts expect the funds in 130/30 products to grow to $1 trillion over the next few years. However it is an open question if these funds actually can deliver on their promises, or are simply a scheme to increase the fees generated for brokerages and hedge funds.

The usual sales pitch involves presenting quantitative back-tested models and presenting results to investors which demonstrate the increased alpha. Naturally these models have the advantage that the managers can easily tweak the selection criteria to provide the results desired over the time frame. The sub-prime CDO fiasco should provide ample evidence that “quant” models that work in back-testing can easily blow up when applied to a real market. The 130/30 models used by fund managers face a similar risk of immediate under-performance.

The stock market performance in January was dismal, NASDAQ was down by over 9.9% and other indexes also suffered significant declines. Most people would assume that the performance of 130/30 funds would shine in this type of environment, and many would be near the top of performance lists. The reality is that the performance of the 130/30 funds in January was effectively lackluster in squeezing excess alpha out of the market. There is no data that demonstrates any type of significant advantage in the market when all the factors are taken into consideration. In fact, the results from publicly available mutual funds with 130/30 strategies show that they have underperformed the indexes as outlined in Verdict Still Out on 130/30 Leveraged Funds at (a performance table is provided here). This can hardly be considered “squeezing excess alpha out of the market”.

Most institutions would have been better off allocating a portion of their money to short funds while placing the majority of their funds (80%+) in long opportunities; if they wanted to achieve better performance with lower fees. Veryan Allen touches on some of these issues in his 130/30 overview. Most investors would be better sticking to traditional products than using 130/30 funds according to Morningstar.

A number of industry specialists would state that 130/30 funds simply limits the long side returns while holding the fund steady in down markets. Another significant issue is that the fees charged for these vehicles are often over-sized compared to other types of funds that institutions can use to achieve comparable exposure. Obviously, a race is on by large financial services firms to acquire more institutional assets in this down market. The 130/30 funds serve as a compelling story, and also deliver out-sized fees to the large financial institutions. One industry quip stated that the collection of fees for a 130/30 fund are usually 0.53% greater than the combination of simply buying equivalent long and short funds. Pension & Investments Online states that a pension fund typically pays 50 to 75 basis points for an active U.S. large-cap strategy, it pays about 25 basis points more for a 130/30 strategy. PIonline views that 130/30 strategy funds are simply a payday for money managers.

Another industry issue is that long managers simply don’t have shorting experience. Some funds will attempt to bring in money managers on board with this type of experience while others will just pick stocks they view as weak as their short candidates. Simply picking the bottom 10% of screens means that many times the manager is selecting the 10% anticipating a rebound; due to their lack of understanding of the criteria that should define a short candidate near the price peaks rather than troughs. For example, the majority of basic fund screening and ranking strategies would have money managers shorting banks now (when they are likely near their bottom) rather than mid-2007 (when they desperately deserved to be shorted). As outlined in the IDD article, "Shorting is a rare talent to begin with, and it's hard to consistently profit on the short side," says Chris Wolf, managing partner at San Francisco-based funds-of-funds Cogo Wolf.’ It is doubtful that very many of these funds will exceed the 130/30 index defined by Andrew Lo at MIT.

An additional concern is “negative carry”, this is the spread in the borrowing cost required to put on the combination of long and short positions. This cost of leverage immediately creates a negative alpha that the fund must overcome to even arrive at par performance. Thomas Kirchner, the manager of the Pennsylvania Avenue Event-Driven Fund (PAEDX), provides an excellent explanation of this issue in his Negative Alpha is Built Into 130/30 Funds commentary.

In some of the cases, the interest on the combined long-short position goes directly back to the sponsoring institution; the large financial services firms are apt to view this as simply another revenue stream and use it as a mechanism to squeeze extra money out of investors. Nor are the disclosure documents very clear on the size of the payments. This entire situation is definitely self-serving and effectively acts as yet another fee targeting customers.

The combination of high fees, minimal short-selling managerial experience, and interest costs are likely to doom 130/30 funds to be underperforming entities. Certainly the marketing blitz from large financial services entities will drive these funds into institutional holdings such as pensions. However individual investor should avoid these funds, and seek other alternatives to create a properly diversified portfolio that can deliver respectable returns over time in both up and down market conditions.